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What happens when you set up an IP licensing subsidiary

This week’s newsletter topic comes from a previous client’s question:

I own 40% of a BVI corporation, and a nonresident alien owns the other 60%. The BVI corporation owns an operating corporation in country X that runs a website which makes money from subscriptions for web services. We are thinking of setting up a 2nd subsidiary in the Cayman Islands to hold IPs (software copyright, trademarks, domain name) and license them to the operating subsidiary, so we can generate an expense for the operating subsidiary. Will the IP subsidiary be a PFIC?

Actually, the first questions that come to my mind are not about passive foreign investment companies (PFICs). Rather, I would first ask:

Are the licensing royalties deductible in country X? (anti base erosion rules)

Do the deductions cause the operating subsidiary to lose key treaty benefits? (limitation on benefits clauses)

Is the nonresident alien shareholder going to be subject to adverse tax rules in his home country? (their version of controlled foreign corporation, or CFC, rules)

Are there transfer pricing issues with the royalties?

But for the moment, we are only interested in PFICs, and specifically whether the IP subsidiary is a PFIC. Today, I will only analyze the income test and the asset test for the IP subsidiary.

Let us make the assumption that the operating subsidiary’s income is entirely nonpassive–that seems correct, given that it runs a website that sells subscription for the website’s services, and we will not dig deeper.

Definition of a PFIC

A foreign corporation is classified as a passive foreign investment company (PFIC) if it meets either 1 of 2 tests:

Income test: At least 75% of its income is passive income

Asset test: At least 50% of its assets produce passive income or are held for the production of passive income

If a foreign corporation meets either the income test or the asset test, then it is a PFIC.

Being a foreign corporation is a requirement. The IP subsidiary is a foreign corporation. See Reg. §§301.7701-2, -3, -5. So we need to check the income test and the asset test.

Royalties are usually passive income

We start with the income test, because the asset test requires us first to understand what is passive income and what is nonpassive income.

Passive income is any income which would be foreign personal holding company income (as defined in section 954(c)). IRC §1297(b)(1).

Foreign personal holding company income includes royalties. IRC §954(c)(1)(A).

At first glance, the IP subsidiary’s situation is straightforward: Its income consists of royalties. Royalties are foreign personal holding company income, which means they are passive income. The IP subsidiary’s income consists of passive income. It meets the income test. It is a PFIC. QED.

But there are exceptions that can apply to royalty income. Let us take a look at those.

The active business exception does not apply

There is an active business exception for royalties:

Foreign personal holding income shall not include rents and royalties which are derived in the active conduct of a trade or business and which are received from a person other than a related person… IRC §954(c)(2)(A).

There are 2 requirements:

The rent must be derived from the active conduct of a trade or business; and

The payer must not be a related person.

The IP subsidiary is not engaged in an active business in the ordinary sense, but as it happens, active business in this context includes a category that is not normally thought of as an active business:

Royalties [are] derived in the active conduct of a trade or business if [the royalties are derived from licensing] property that the licensor has developed, created, or produced, or has acquired and added substantial value to, but only so long as the licensor is regularly engaged in the development, creation or production of, or in the acquisition and addition of substantial value to, property of such kind… Reg. §1.954-2(d)(1)(i).

Or putting it in another way, if a company regularly develops IP of a similar kind, either because its normal business requires it to develop IP (for example, a pharmaceutical company) or because it is in the business of developing IP (for example, a software developer), then the royalties from licensing the IP is derived from active business.

Here, the IP subsidiary does not develop the IP, nor does it make derivative works or add value once it has been assigned the IP. It is also not the result of any business function the subsidiary performs, such as marketing. The royalties are not from an active business.

The royalties do not fit the active business exception.

But a related person exception applies

There is also a related person exception to royalties:

Except as provided in regulations, the term “passive income” does not include any income […] which is interest, a dividend, or a rent or royalty, which is received or accrued from a related person (within the meaning of section 954(d)(3)) to the extent such income is properly allocable (under regulations prescribed by the Secretary) to income of such related person which is not passive income. IRC §1297(b)(2)(C).

We assumed that the operating subsidiary’s income consisted entirely of nonpassive income, so the royalties the operating subsidiary paid to the IP subsidiary were not allocable to passive income. It remains to ask whether the operating subsidiary is a related person.

Section 954(d)(3) defines related person as follows:

[A] person is a related person with respect to a [foreign corporation] if

[…]

(B) such person is a corporation, partnership, trust, or estate which is controlled by the same person or persons which control the [foreign corporation].

For purposes of the preceding sentence, control means, with respect to a corporation, the ownership, directly or indirectly, of stock possessing more than 50 percent of the total voting power of all classes of stock entitled to vote or of the total value of stock of such corporation. IRC §954(d)(3).

The same BVI parent owns 100% of the shares of both the operating subsidiary and the IP subsidiary. The parent controls both subsidiaries. Therefore, the operating subsidiary is a related person to the IP subsidiary.

The operating subsidiary is a related person to the IP subsidiary, and the operating subsidiary is not using passive income to pay royalties to the IP subsidiary. The royalties are nonpassive under this related person exception. And as far as I am aware, the IRS has not adopted or even proposed regulations that would remove the royalties from the exception.

The royalties are nonpassive income

Despite being what we would normally think of as a classic example of a holding company whose only income is “passive”, the royalties the IP subsidiary collects are nonpassive in the PFIC context. This is because it collects royalties from a related person–its sister company the operating subsidiary–, and the operating subsidiary has not used passive income to pay the royalties. As a result, the subsidiary is not a PFIC under the income test.

The IP subsidiary probably does not meet the asset test

We turn to the asset test, because satisfying either the income test or the asset test would make the IP subsidiary a PFIC.

The IP subsidiary owns 2 types of assets: cash and IP. Cash is a passive asset. Notice 88-22. For the IP subsidiary to avoid being a PFIC under the asset test, its IP must be nonpassive, and the IP must be more valuable than the cash.

The guidance for whether the IP is a passive asset is not as clear.

Passive assets are assets “which produce passive income or are held for the production of passive income”. IRC §1297(a)(2).

The IPs currently produce nonpassive income–royalties. And the subsidiary was formed to license the IP to the parent, so the subsidiary was assigned the IP so that the IP can produce nonpassive income.

But it is plausible to argue that the IP is held for the production of gains, because it can be sold for a gain later. Gains from the disposition of property that produces royalties are passive income. IRC §954(c)(1)(B)(i). There is no exception for properties that produce nonpassive royalties. See Reg. §1.954-2(e).

Fortunately, the IRS appears to not favor this argument:

Generally, intangible assets that produce identifiable amounts of income, such as patents and licenses, will be characterized on the basis of the income derived from the intangible assets. Notice 88-22.

This treatment is essentially consistent with how IP is valued: Patents and copyrights are valued more or less solely by the income they are expected to generate, whether through implementation in a product or through licenses, so any gain from the sale of a patent or copyright is simply the present value of the remaining–and diminishing–future income. Trademarks are trickier, but we will rely on the IRS’s word and classify the trademarks by the income they generate as well.

The IP subsidiary’s IPs generate nonpassive income–specifically licensing royalties from a related party–, so they are classified as nonpassive assets.

A check the box election may be appropriate

The purpose of the IP subsidiary is to generate a deductible expense for the operating subsidiary in country X. From country X’s point of view, it is likely not relevant whether US tax law says the IP licensor is the parent or the IP subsidiary.

A Cayman limited company can elect its US tax classification. It may be prudent to make a check the box election for the IP subsidiary to make it a disregarded entity. This would make the IP subsidiary something other than a corporation, which in turn means it cannot be a PFIC.

Thank you

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